Crossroads: Which Direction Is Microsoft Headed?

| About: Microsoft Corporation (MSFT)

Microsoft (NASDAQ:MSFT) is facing yet another pivotal moment in its history at the moment, and investors must decide for themselves whether the company's current direction will be successful. Over the past decade, Microsoft's share price has largely remained stagnant - 10 years ago it was trading in the same $24 - $28 price range that we're seeing today. This is despite the fact that EPS has grown from $0.69/share in 2003 to around $1.85/share currently, which represents a 268% increase. It doesn't stop there, as Microsoft has also consistently increased dividends over the past 10 years as well, also by a few hundred percent.

So why has share price not responded to these positive catalysts? Back in 2003, investors were willing to accept a PE ratio of 36.5 (average) to own Microsoft, while today the PE ratio stands at 14.5. In other words, investors saw a much higher potential for growth in the company in the past than they do today, and were willing to pay a premium price to partake in that growth. Even though that earnings growth did materialize, investors did not believe that growth would continue and subsequently were not willing to pay as high a premium to own the company's stock. Following is a table showing average PE ratios for Microsoft over the past decade (source: msn Money).

Year Avg. PE Ratio EPS ($)
2003 36.5 0.69
2004 35.7 0.75
2005 23.6 1.12
2006 21.7 1.20
2007 19.9 1.42
2008 16.3 1.87
2009 13.4 1.62
2010 13.1 2.10
2011 9.5 2.69
2012 14.2 2.00

Despite the declining PE, share price has remained flat since earnings themselves have been steadily increasing, as shown in the following chart:

Microsoft's earnings growth over the past decade has come almost exclusively from sales of its flagship Windows operating systems, business products (notable MS-Office), and backend solutions to corporate customers. In the business world Microsoft remains top dog with a commanding market share circa 90%.

Outside of these core products however, Microsoft has not been as successful, and outright flopped on several of its ventures, including some key new markets that have developed such as mobile computing, search, and media. Let's look at some of these key failures specifically.


Microsoft has poured billions into its Bing internet search provider, yet still struggles to make headway against the only main competitor in this field, Google (NASDAQ:GOOG). Although Bing has made headway in the US, and now holds over a 15% market share, Google still has a commanding lead at 60%. Worldwide, things are bleaker for Microsoft, with Bing only accounting for around 4% of all searches.

Google is using this advantage in search to leverage its other products, some of which also have a direct (albeit small for the moment) effect on Microsoft. In addition to search, Google also provides a full range of other web-based services including maps, email, and an online suite of "Office" applications including word processing, spreadsheet, and presentation software available for free. It's unlikely that most large corporations would forego traditional MS-Office applications for this service, but small businesses and consumers are jumping on board.

Mobile Computing

Microsoft has been extremely slow to respond to the explosion in popularity of mobile devices, notably smart phones and tablets that has occurred over the past several years. Apple (NASDAQ:AAPL) has been the clear leader here with its signature iPad and iPhone devices, however recently devices made by a multitude of manufacturers utilizing Google's Android platform now represent the single largest chunk of all mobile devices sold. A recent report shows that in Q3/2012 75% of all smartphones shipped were Android based, 15% were Apple devices, while Microsoft Windows based phones only accounted for a meager 2% - virtually insignificant.

Media / Entertainment

Microsoft's foray into the video game market began in 2001 with its Xbox console, and followed up with the Xbox 360 in 2005. Over 70 million units of the Xbox 360 have now been sold as of September. Despite being a popular system however, the company's gaming division continually lost money - billions. Things in recent years are turning around however, with 2008 being the first year that the division achieved a profit, and the Xbox has now overtaken both Sony's (NYSE:SNE) Playstation and Nintendo's (OTCPK:NTDOF) Wii systems to become the overall market leader.

But there's more to home entertainment than video games these days, and Microsoft has not horribly at keeping up with the likes of Amazon (NASDAQ:AMZN), and Apple in the digital books, music, and movies markets. These products are so lucrative that Amazon sells its trademark Kindle devices at cost, just to get a foot in the door to sell high margin media products. Microsoft's Zune was a complete failure by most accounts, however Microsoft is now making steps in the right direction with its Xbox music pass service, as we'll see below.


In summary, I believe the missteps outlined above are one of the key reasons why Microsoft's share price has not grown commensurate with its earnings. Microsoft needs a catalyst to regain investor's confidence, and I believe that catalyst is Windows 8. Last month Microsoft released its new Windows 8 operating system as well as its first foray into tablet hardware sales with the Microsoft Surface. These products have both received mixed reviews, however the negative reviews have largely focused on the fact that the new operating system is too big a departure from what users are familiar with. I argue that this is not a negative, but instead a big change is exactly what Microsoft needs!

Windows 8 goes a long way to addressing all of the issues I've touched on above. Bing is now integral to the operating system, with a Bing search app, a Bing maps app, and Bing integration with Internal Explorer pre-installed. I am an avid Googler myself, but after using the Bing apps for the past month I am quite impressed and am perfectly satisfied using it as my primary search engine. It will be interesting to see over the next few months how many users feel the same, and how many go out of their way to install the Google search app as a replacement.

The defining feature of Windows 8 is that it is designed with mobile computing in mind. The entire operating system is touch enabled and works beautifully, as evidenced by the sleek Microsoft surface. I've purchased one of these devices as well and haven't gone back to the iPad since. For many users, the ability to use MS-Office applications on a tablet is a huge selling point and transforms the tablet from a mere entertainment/consumer device to something amenable for business use. Windows 8 is also now available on phones as well, with Nokia's Lumia seeing some fairly decent reviews, and rumors about Microsoft developing its own phone for a 2013 release are also swirling. One of the key advantages with Windows 8 that I think is overlooked by many is that it seamlessly allows all of a user's devices to sync and work together. Documents created on one device are immediately available on tablets and phones through Microsoft's Skydrive service which is also built-in to the operating system. Microsoft now operates a Windows Store which sells apps, not unlike Apple's iTunes albeit with only a fraction of the selection at the time being.

Finally, Xbox features such as gaming, movies, music, and entertainment are all built into Windows 8 as well. Free music can be streamed using the music app, TV shows and movies can be purchased using the video app, and games can be purchased and downloaded through the Windows store. The games app allows for Xbox achievements and communication with friends, regardless of the type of device the user is logged in on.


Do other investors have as positive an outlook as I do on Microsoft's future products? Probably not. As with any major change it will take a significant amount of time for users to make the switch and adapt to the new system. And yes, there are many who won't make the switch at all and will jump ship to a competitors product.

I feel that Windows 8 and the corresponding unification of all Windows based devices (including Xbox) will allow Microsoft to regain ground in the search, mobile computing, and media markets - and the bar is pretty low to start showing signs of improvement. With a 4% market share in search, a 2% share in smartphones, and virtually non-existent share in music / movies, coupled with a new system that takes huge strides in making all of these deficiencies accessible to everyone who uses a Windows based system for their work (90% of PC users), we have a winner.

Readers of my previous articles know that I like to take a completely analytical approach to my investments using a value-discount strategy. I am not going to go through the entire analysis in this article but based on my valuation approach, I arrive at a fair value of $26.40 per share based on past performance and a projected EPS growth rate of 15%/yr.

Due to the reasons I've outlined above however, I think the growth prospects for Microsoft over the next five years are actually much better than that. I think a more realistic valuation based on my expectation that Windows 8 will be a success is around $35 - $38/share. I am therefore buying at today's (11/21) price of $26.95 and will look to add to the position on dips lower.

Disclosure: I am long MSFT, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.